INSIGHTS BLOG > The Expected Impact of Decreasing Taxes on Medical Cannabis: A Case Study

In Washington, medical cannabis patients have been exempt from paying sales taxes, but they’re still required to pay a 37% excise tax on cannabis. Under a new law that just took effect, medical patients no longer have to pay the 37% excise tax on products that are compliant with the more rigorous testing standards that differentiate medical products from recreational products.

Some detail on standard vs. more rigorous testing:

Manufacturers in the state are required to submit all medical and adult-use products to labs for testing, but producers can voluntarily have additional testing done—to screen for heavy metals, for example—that isn’t otherwise required.

So before the new law, medical users paid both sales and excise taxes on products with standard testing, but they paid only excise taxes on products with more rigorous testing. After the new law, medical users now pay no sales or excise taxes on products with more rigorous testing. Presumably, before and after the new law, recreational users may purchase products with more rigorous testing, but they still have to pay both sales and excise taxes on those products. Also, presumably products with more rigorous testing have higher prices to cover the costs of the extra testing.

How will this new law change (i) the selection and (ii) the prices of products that are put through the more rigorous testing?

I assume any given product is supplied either wholly with standard testing or wholly with rigorous testing, that is, the supplier doesn’t provide some portion with standard testing to recreational users and some portion with more rigorous testing to medical users.

Let’s consider a concrete example. Suppose a product with standard testing sells for $40, while that same products with more rigorous testing sells for $42, due to the added costs of more testing.

As shown in Figure 1, under standard testing:

• Price: Medical and recreational users both pay 6.5% sales tax and 37% excise tax on the product price of $40, so the price including taxes for both medical and recreational users is 1.435 x $40 = $57.40
• Value: The value to medical and recreational users is the value each places on the product plus the value to each of standard testing.

Under more rigorous testing, 

• Price: 
  • Recreational users pay 6.5% sales tax and 37% excise tax on the product price of $42, so the price including taxes for recreational users is 1.435 x $42 = $60.27.
  • Before the new law, medical users paid 37% excise tax on the product price of $42, so the price including taxes for medical users was 1.37 x $42 = $57.54.
  • After the new law, medical users pay no tax on the product price of $42.00.
• Value: The value to medical and recreational users is the value each places on the product plus the value to each of more rigorous testing.

Figure 1

Outcomes Under the New Law

Under the new law, more products that had only been subject to standard testing will now be rigorously tested, where the number of products that switch from standard to rigorous testing will be greater when:

• Medical consumers are more sensitive to price
• Recreational consumers are less sensitive to price
• More recreational consumers value rigorous testing
• The added costs of rigorous testing are lower
• Products sales are more evenly divided between recreational and medical consumers

Follow-on effects

• Prices of rigorously tested products (excluding taxes) might increase, less than or equal to the amount of tax savings, i.e., producers may capture some of the price drops to medical consumers, where prices will increase more when: 
  • Medical consumers are less sensitive to price
  • The portion of total sales to medical consumers is larger
  • There is less competition
• The cost of rigorous testing services might increase as demand and profitability of rigorous tests increase.

Reasoning Behind Predicted Outcomes

One way to think about this that doesn’t use too much math is this. 

Each product sold has some mix of recreational and medical consumers: 

(1)        Q_i = Q_i(Rec) + Q_i(Med),

where 

Q_i is the total sales volume (in units) of product i

Q_i(Rec) is the volume of product i sold to recreational consumers

Q_i(Med) is the volume of product i sold to medical consumers

Some products appeal more to recreational users: 

(2)        Q_j = Q_j(Rec) + Q_j(Med),   where Q_j(Rec) > Q_j(Med),

while other products appeal more to medical users:

(3)        Q_k = Q_k(Rec) + Q_k(Med),   where Q_k(Rec) < Q_k(Med).

Say there are N total products, some with standard testing and others with more rigorous testing. I assume products with standard testing appeal more to recreational consumers than medical consumers (that is, products that appeal more to recreational consumers are more likely to have standard testing), while products with rigorous testing appeal more to medical consumers than recreational consumers. 

For the products sold with standard testing before the new law was enacted, producers had the option of subjecting those products to more rigorous testing and charging the higher prices, with sales tax breaks for medical consumers, but they chose not to do so. This means that for the products sold with standard testing before the new law was enacted, on the whole, medical and recreational users of those products valued the rigorous testing less than the associated price differentials.

Now, line up the N products, starting with those with the highest portion of sales to recreational consumers and ending with those products with the lowest portion of sales to recreational users:

(4)        Q₁, Q₂, …, Q_N  where 

The products with the highest portion of sales to recreational customers will have standard testing:

(5)        Sales of Standard Testing Products: Q₁, Q₂, Q₃, …, Q_j-1, Q_j. ,

while the products with the highest portion of sales to medical customers will have more rigorous testing:

(6)        Sales of Rigorous Testing Products: Q_j+1, Q_j+2, …, Q_N-2, Q_N-1, Q_N

Before the new law took effect, the cutoff point for determining standard vs. rigorous testing landed between products j and j+1. For the products at the cutoff point, j and j+1, there are just enough recreational users relative to medical users for product j so that it’s more profitable for the supplier to not undertake rigorous testing for product j. And, there are just enough medical users relative to recreational users for product j+1 so that it’s more profitable for the supplier to undertake rigorous testing for product j+1.

The outcomes I propose under the new law come from a comparison of the products just to the left of the cutoff point with those just to the right.